How austerity was based on market panic

Markets were full of fear. When that receded, so did the bond spreads.

When countries across Europe were putting together austerity policies in 2011, the orthodox reasoning was that the debt and deficit of the nations were out of control, and that this was being communicated by the markets, in the form of bond yields.

But did nations actually base their estimates of the need for austerity on the fiscal fundamentals? Or were they misled by market reaction? A research paper from Paul De Grauwe and Yuemei Ji breaks down the question.

It's certainly the case that the austerity was based, almost entirely, on the state of the market. The authors compare the extent of austerity measures in 2011 with the spreads of the nations' bonds (the difference between each country’s 10-year government bond rate and the German 10-year government bond rate), and find a near-perfect correlation:

Austerity measures and spreads in 2011

The authors write:

There can be little doubt. Financial markets exerted different degrees of pressure on countries. By raising the spreads they forced some countries to engage in severe austerity programs. Other countries did not experience increases in spreads and as a result did not feel much urge to apply the austerity medicine.

Now, that in itself is not particularly problematic. After all, if the financial markets are rationally responding to problems in the respective nations' finances, then it makes sense to try and calm them by getting finances under control. But if the markets are instead in the throes of irrational panic, then basing policy around their whims is problematic.

Ji and de Grauwe then come up with two proxies to test what it actually was which was driving the financial markets. If the markets are acting rationally, then as fundamentals improve, the spreads should fall. So, starting in mid-2012, they compare the change in debt-to-GDP ratio (just one possible measure of fiscal health) to the change in spread values.

They find that, over the period they're examining, debt-to-GDP ratio increases in every one of the ten nations they study. Despite this, however, the spreads decrease in each — and those decreases aren't particularly correlated with the debt-to-GDP change:

 

Change in debt-to-GDP ratio vs. spreads since 2012Q2

The bond markets don't appear to pay much attention to the basic financial health of the nations. What they do pay attention to is the European Central Bank. The paper states that:

The decision by the ECB in 2012 to commit itself to unlimited support of the government bond markets was a game changer in the Eurozone. It had dramatic effects. By taking away the intense existential fears that the collapse of the Eurozone was imminent the ECB’s lender of last resort commitment pacified government bond markets and led to a strong decline in the spreads of the Eurozone countries.

In the summer of 2012, the ECB removed fear from the equation. What happened then was a widespread collapse in bond spreads. But the collapse wasn't uniform; instead, "countries whose spread had climbed the most prior to the ECB announcement experienced the strongest decline in their spreads". By taking away panic, the ECB lets us see that almost all of the prior variation in the bond spreads had been as a result of that panic.

Basing policy on calm sensible market reactions might work; basing it on the reaction of markets in existential fear probably wouldn't. That's traditionally the time when politicians start trying to lead markets, rather than follow them. And, sure enough, the authors repeat a calculation confirmed by many others: panic-driven austerity has crushed growth in the nations it's been practiced…

Austerity and GDP growth 2011-2012

…and has hurt fiscal fundamentals in those same nations, with debt-to-GDP ratios getting worse the more austerity is practiced:

 

Austerity and increases in debt-to-GDP ratios

The TUC's Duncan Weldon (whose tweets first pointed me to the research) sums up the lessons we've learned:

  1. Financial markets are perfectly capable of acting irrationally. Market panic drove extreme austerity in Southern Europe.
  2. Extreme austerity has proved self-defeating – it means debt/GDP ratios are higher not lower.
  3. Markets, to quote the IMF’s Chief Economist, can be ‘schizophrenic’ – they initially reward harsh austerity measures and then panic when they, predictably, lead to weaker growth.
  4. The end result is that market panic, followed by policy-maker panic, has imposed huge economic and social costs across Europe

Seems like if politicians really really want to base their decisions on the ill-thought-out panic of large numbers of people, they ought to at least wait for an election.

Gambling with out future. Photograph: Getty Images

Alex Hern is a technology reporter for the Guardian. He was formerly staff writer at the New Statesman. You should follow Alex on Twitter.

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How Labour risks becoming a party without a country

Without establishing the role of Labour in modern Britain, the party is unlikely ever to govern again.

“In my time of dying, want nobody to mourn

All I want for you to do is take my body home”

- Blind Willie Johnson

The Conservative Party is preparing itself for a bloody civil war. Conservative MPs will tell anyone who wants to know (Labour MPs and journalists included) that there are 100 Conservative MPs sitting on letters calling for a leadership contest. When? Whenever they want to. This impending war has many reasons: ancient feuds, bad blood, personal spite and enmity, thwarted ambition, and of course, the European Union.

Fundamentally, at the heart of the Tory war over the European Union is the vexed question of ‘What is Britain’s place in the World?’ That this question remains unanswered a quarter of a century after it first decimated the Conservative Party is not a sign that the Party is incapable of answering the question, but that it has no settled view on what the correct answer should be.

The war persists because the truth is that there is no compromise solution. The two competing answers are binary opposites: internationalist or insular nationalist, co-habitation is an impossibility.

The Tories, in any event, are prepared to keep on asking this question, seemingly to the point of destruction. For the most part, Labour has answered this question: Britain will succeed as an outward looking, internationalist state. The equally important question facing the Labour Party is ‘What is the place of the Labour Party in modern Britain?’ Without answering this question, Labour is unlikely to govern ever again and in contrast to the Tories, Labour has so far refused to acknowledge that such a question is being asked of it by the people it was founded to serve. At its heart, this is a question about England and the rapidly changing nature of the United Kingdom.

In the wake of the 2016 elections, the approach that Labour needs to take with regard to the ‘English question’ is more important than ever before. With Scotland out of reach for at least a generation (assuming it remains within the United Kingdom) and with Labour’s share of the vote falling back in Wales in the face of strong challenges from Plaid Cymru and UKIP, Labour will need to rely upon winning vast swathes of England if we are to form a government in 2020.

In a new book published this week, Labour’s Identity Crisis, Tristram Hunt has brought together Labour MPs, activists and parliamentary candidates from the 2015 general election to explore the challenges facing Labour in England and how the party should address these, not purely as an electoral device, but as a matter of principle.

My contribution to the book was inspired by Led Zeppelin’s Physical Graffiti. The track list reads like the score for a musical tragedy based upon the Labour Party from 2010 onwards: In My Time of Dying, Trampled Underfoot, Sick Again, Ten Years Gone. 

Continued Labour introspection is increasingly tiresome for the political commentariat – even boring – and Labour’s Identity Crisis is a genuinely exciting attempt to swinge through this inertia. As well as exploring our most recent failure, the book attempts to chart the course towards the next Labour victory: political cartography at its most urgent.

This collection of essays represents an overdue effort to answer the question that the Party has sought to sidestep for too long.  In the run up to 2020, as the United Kingdom continues to atomise, the Labour Party must have an ambitious, compelling vision for England, or else risks becoming a party without a country.

Jamie Reed is Labour MP for Copeland.